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Inflation report: Cost of living looks set to rise

Inflation, or the rising cost of living, is set to reach 2.4% in 2022,1 according to the Bank of England, potentially leading to interest rate increases to return it to its 2% target. 

The Monetary Policy Committee’s (MPC) third quarterly inflation report of 2019 showed that Consumer Price Inflation (CPI), which doesn’t include the costs of owning a home, is projected to fall below its current level of 2% over the next six months, largely due to declining energy prices.2

However, it is expected to pick up from next year as the as the impact of lower energy prices fades, import prices rise as a result of sterling’s recent falls, and domestic inflationary pressures increase.

The Bank forecasts that CPI will reach 2.2% in the third quarter of 2021, higher than the 2.1% it predicted in May, and 2.4% in the third quarter of 2022.3

The MPC voted unanimously to leave interest rates unchanged at 0.75% in August, but warned that if there is a smooth Brexit, increases in interest rates “at a gradual pace and to a limited extent” may be required to keep inflation under control.

However, it acknowledged that the monetary policy response to Brexit could be “in either direction”4 depending on the path the economy takes following the UK’s withdrawal from the EU.

Why inflation matters

Inflation usually occurs when an economy is growing, or when there’s a sharp increase in the supply of money.

The reason inflation matters is that it eats into the purchasing power of your cash over time, so it’s important for investors to consider the impact this will have on their finances. For example, someone with savings held in a deposit account which pays less than the rate of inflation will see the actual value of their money shrink in real terms, as costs are rising more quickly than the returns on their savings.

Over the long term, investing in equities can potentially help protect against the effects of rising living costs, as companies are often possibly able to increase their prices in line with inflation. This may lead to higher share prices as company earnings improve.

However, if there’s a sudden unexpected sharp rise in inflation, shares prices could fall if investors are worried that this may herald a period of economic uncertainty, so there are no guarantees.

Companies that tend to perform well when living costs are rising

Certain sectors tend to be more resilient than others in an inflationary environment. For example, those that produce essential consumer goods and staples that will always be in demand, such as food, drink and medicines typically fare better than those producing non-essential items. This is because when living costs are rising, people tend to reduce their spending on things that they can do without.

Other companies which are usually in a stronger position to combat inflation include infrastructure companies, which often have inflation-linked cashflows, and mining companies, as strong economic growth typically leads to construction, which can potentially boost demand for base metals and iron ore.

References

1, 2, 3 and 4 The Bank of England, Inflation Report, August 2019

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